If 2013 was considered a bad year for gold, it was a disaster for gold mining equities (GDX) that were slashed by almost 50% by mid-year. The April and June sell-offs brought gold (GLD) down to USD 1,300 - a level that it had not witnessed since September 2010. Many found this sell-off was more of a frenzy and nervous reaction to a series of bad news: the U.S. Treasury announcing it is considering tapering its economic stimulus program, Cyprus revealing it will sell off 'excess' gold reserves to finance its bailout by the European Central Bank, not to mention weaker Chinese economic growth figures. The outlook on gold was bad, and dragged gold mining equities along with it. But there is more to the gold mining story - and if investors agree that the past six months were in fact a frenzy, and start looking closer, they will then find a number of benefits and investment opportunities that were overlooked in the past.
Gold mining equities have fallen to great discounted levels and thus have turned not just into good buying opportunities, but value investments as well. To a large degree, it was forced selling by big institutions and funds, which caused the capitulation in precious metal equities. Virtually every major bank has lowered its price target of the yellow metal to levels which were out of imagination one or two years ago. The business model of gold mining, which has always been to produce gold at the lowest possible costs while adding to reserves in the ground, was called death.
So, why gold mining equities? For starters, we find them a play on gold as well. Seasoned investors who understand that the cracks in the financial system have not disappeared but are bigger today than ever before, will agree that gold has not left the bull market cycle despite the recent correction. So why shouldn't these positive fundamentals not reflect on gold mining shares as well? Well, there is more to it - and here is where I trace the benefits of investments in gold mining shares, and how to make the best of it in this challenging market environment.
Why is investor sentiment negative towards gold mining equities?
As it turns out, the massive drop in the gold price was not driven primarily by a drop in physical demand for gold. It was rather naked short selling on the COMEX where stop orders from small buyers were taken out by the shorts in massive volumes. When the gold futures were falling from a cliff, holders of gold ETFs became nervous and started to redeem their shares too. ETFs were the primary seller on the physical side. As confirmed by the World Gold Council, ETFs accounted for a 13% drop in overall investment demand in Q1. Excluding these ETF outflows, overall demand witnessed a year-on-year growth in Q1. There are several facts that support this argument, namely higher demand in other markets (India and China, both seeing 15% and 19% annual growth in Q1 global jewelry demand), as well as rising physical demand for gold in America. Additionally, central banks made net purchases of gold for the ninth consecutive quarter in Q1, which accounted for 11% of demand. On the supply side, even though mining explorations continued and global supply increased 4% annually in Q1, according to the World Gold Council this was not enough to confront the largely negative sentiment on gold and related sectors stirred by the sell-offs.
Because of the dive in the gold price (that is now picking up), investors became fearful and had no answer to the following questions: How will the lower gold price impact gold mining companies? How will the lower gold price affect their reserves and what impairments will have to be made once a project is now longer economically feasible? How could this effect dividend policies and pay outs to investors?
This negative sentiment becomes clear when taking a look at the XAU Index/Gold ratio, whereby the XAU stands for the Philadelphia Gold and Silver Equity Index, an index of international listed precious metal mining companies. As seen in the chart, the ratio has capitulated in June and has reached the lowest level in 20 years.
Following the capitulation of the whole precious metals complex in June, it is worthwhile noting that the gold silver ratio (GSR) is normally a good indicator for a trend reversal. When the GSR is rising, i.e. gold is outperforming silver (SLV), this means that liquidity is flowing out of precious metals and silver, as the less liquid metal, is underperforming gold as a result. A declining GSR means the opposite, i.e. money is flowing into precious metals and the money flow results in a faster price appreciation of silver compared to gold. In July, the GSR started to fall and is still falling. In addition, gold is in backwardation (spot gold is trading higher than the nearest future price) and gold lease rates are negative, which means someone is paying money to hold gold. All this points to tight physical supply where demand is overwhelming. The falling GSR and the unusually high open interest in out of the money call options on silver could suggest that precious metals are at a major bottom and that the next leg up is around the corner.
The wide gap between gold and gold mining shares
As shown in the following chart, the gap between gold and gold mining shares has never been wider. Gold mining shares as represented through the XAU Index peaked in December 2010 and have been in a bear market since then whereby the sector has lost 45% in value. The complete disconnect from the gold price and the valuation compression of gold mining equities today are unprecedented. The question therefore is if precious metal equities are a value trap because the industry will not be able to absorb the low gold price or if this is a lifetime buying opportunity because:
- the sector is historically cheap on all metrics
- gold mining companies have been around for decades and were profitable businesses also at much lower gold prices
- gold mining companies are slashing their production costs aggressively while disposing unprofitable, high cost mines and adopting a much better capital discipline
- gold will remain attractive because the world today is a very risky place, financially and politically.
As gold is bottoming out and gold miners are adjusting their business model towards profitability, quality and transparency we think it is only a question of time until the generalists will get back to this market after they were staying away (for good reason) while the industry was challenged by too many problems. For many investors, gold mining equities were considered a non-investible asset class. But things are changing to the good and we believe that gold mining equities today are an asset class of absolute compelling value.
Smart money heading to gold mining stocks
Evidentially, we are not alone in the belief that there is value to be found in gold mining equities, as we find heavyweight investors directing their smart money to this sector, benefiting from their discounted levels and thereby backing gold mining equities. Earlier in May, the U.S. Securities and Exchange Commission released that George Soros reported over USD239 million in gold positions, and acquired USD25 million in call options on junior gold mining stocks (GDXJ) and another 1.1 million shares of senior gold miner ETFs. Additionally, renowned international investor Dr. Marc Faber made the statement that "gold and silver mining stocks have the potential to rebound by between 30% and 40%". And just recently, Canadian billionaire Ned Goodman stated on Bloomberg on August 13th that "I'm more bullish on gold now than I have ever been" and that miners of precious metals are "dirt cheap".
Where is the value when in investing in gold mining equities?
We think that this gold bull market is far from being over. In comparison to the treasury bonds bull market, which lasted for 32 years, the current 12 year bull market in gold looks relatively young. Gold remains a store of value, and is internationally accepted due to its marketability and liquidity. Gold is not an investment, but it is money by its very nature. We think that with the sell-offs in April and June, gold has changed from the weak paper hands (small investors who trade gold on fractional gold markets such as the COMEX) to the strong hands, i.e. Asian buyers who buy gold in physical form for savings and wealth preservation. Additionally, international demand is growing as cited by the World Gold Council, whether on the level of central banks, or country level namely India and China. Specifically, we learned from a leading Swiss gold refinery in June that the month of May was their strongest month in terms of demand for physical gold deliveries, outpacing their prior record in March 2009.
It is our view that at current prices gold mining stocks offer a bargain opportunity. On one hand gold mining equities are extremely cheap and discount a gold price of approximately $1,000 per ounce. By owning gold equities an investor is capitalizing on gold, but at a great discount. On the other hand, at current valuations, "in-situ" ounces in the ground are historically cheap and some companies do not get any value for their gold in the ground at all because the investor community is pricing gold equities based on free cash flow only, the rest does not count at the moment.
Normally, gold mining stocks perform well when the overall equity market performs poorly. Of course, gold and gold equities suffered a big deal this year as the US equity market got all the attention with new all-time highs. We think the overall equity markets are working on a major rolling top and the recent strength in gold and gold mining shares may point to this reversal of the trend.
Gold is not dead, but it is the place where the smart money is heading towards, and a value investment worth considering, particularly quality gold producers.
Some pointers on your investment strategy
I would like to take the opportunity to share some criteria or points of consideration we emphasize at Precious Capital to ensure value investment and protection. On a general level, we prefer companies, which generate free cash flow after CAPEX and net working capital expenditure, specifically, mid-tier gold producers with cheap production costs. We highlight value by investing in higher grade and lower cost producing companies, as high production costs are often a function of mining low-grade gold deposits. Other criteria worth considering are production margins (by avoiding low-grade producing companies where margins largely depend on by-product credits such as copper), exploration success (which promise leverage to gold price as production grows), and cost control, as we believe that companies which generate shareholder value mainly by short-term production maximization regularly see themselves faced with long-term strategic challenges. Currently our favorite picks are Alacer Gold (OTC:ALIAF), Torex Gold (OTC:TORXF), Timmins Gold Corp (TGD) and Kirkland Lake Gold (OTC:KGILF).
These are a few "general" investment considerations that we consider and which hopefully help to remove investor's concerns, which I referred to earlier. But these criteria are not discussed nor considered within ETF investments designed to reflect an index and are largely susceptible to sentiment. So what to do?
Moving away from ETFs and volatility - Active Management is Key
The overwhelming negative sentiment towards gold mining shares has overlooked many important criteria of investment strategies, particularly company management. Some gold mining firms have made bold management decisions to adjust to the currently low gold price environment. Many companies have altered their production strategies by focusing on economics, cost discipline and cash flow generation. Such important operational decisions, which also involve exploration and development next to production, were sometimes largely ignored in the past. Not only that, but in an attempt to regain confidence in the sector, these companies are now promising more transparency in their cost figures. This transformation needs to be analyzed and taken into consideration. Buying into ETFs will only continue the same path, and not benefit from the real opportunities in this sector. The focus should be on quality and on those companies, which are best positioned to manage the transition towards profitability and internal growth. In times like these, your investment should be a judgment call - an investor should not blindly invest in an index and see the outcome (likely low or negative). To make the best of this investment, don't sit back - go and see what gold mining firms have to offer, evaluate their changing strategies and measures, and calculate if they will deliver promised results. In the current market environment it is time to step away from 'convenient' passive management and select an actively managed fund, with a well-defined investment focus and selection process in order to pick the right and most promising stocks.
Florian Siegfried is the CEO of Precious Capital Ltd., a Zurich-based fund specializing in global mining investments. Precious Capital is the manager of the Precious Capital Global Mining and Metals Fund which is focusing on mid-tier precious metal equities.